The scenario envisioned by the BPI is of a five-year investment by a business or a saver -- say, a private equity fund buying a stake in a foreign company. The BPI compares how local policies and conditions would affect the same investment in different countries. In other words, it asks how the value of the principal and the return will change depending only on where the investment is made. It also assumes that the investor reinvests the asset's returns during the five-year period, then sells the asset and brings all the money home.
In calculating the BPI, the first factor to consider is the growth of the asset's value. The BPI starts with the International Monetary Fund's forecasts for five years of economic growth, adjusted for inflation. Implicitly, the BPI assumes that when an economy grows, a given chunk of that economy expands in equal proportion. Then the BPI discounts the asset's value by the risk of a financial crisis or security issues that could hamper the investment. In other words, a default on sovereign debt or a civil war could derail economic growth enough to put a dent in the value of the investment's principal and return. These risks are measured using Standard and Poor's sovereign debt ratings and the World Bank's Worldwide Governance Indicators for political stability and rule of law.
Next, local factors may erode the profit after it appears. These include the payment of bribes and kickbacks (judged by Transparency International's Corruption Perceptions Index), expropriation or nationalization of the asset by the local government (from the International Property Rights Index published by the Property Rights Alliance and Americans for Tax Reform), and self-dealing by local managers. This last risk involves the possibility that employees or executives will eat away at profits by giving themselves perks, excessive pay packages, or other sweetheart deals. The BPI assesses it using an index of investor protection compiled by the World Bank with methodology proposed by Simeon Djankov, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer.
Finally, there is the question of how much the profits will be worth once they return to the investor. The BPI first asks whether the target country for the investment has any capital controls in place, since these may restrict the repatriation of profits; the metric here is Menzie Chinn and Hiro Ito's index of financial openness. The last issue is whether exchange rates will change enough over five years to affect the value of the investment. For this, I created an algorithm that simulates long-term convergence of purchasing power parity -- essentially, the notion that as poorer countries become richer, their currencies will gain value in real terms. This doesn't happen overnight, of course, but during a period of several years it may begin to occur.
The countries that score poorly in the BPI do so for a variety of different reasons, but there are some common threads. Angola and Venezuela, for instance, are two resource-driven economies with the potential to grow very quickly. Alas, a raft of issues erodes the attractiveness of investing in either of them. Angola has strict capital controls that could affect the repatriation of profits, and Venezuela's currency might actually depreciate in real terms. Both countries fall short in the protection of investors from the use of unscrupulous tactics by government and private partners, and corruption is rampant. Lebanon and Pakistan aren't much better: Security, capital controls, and expropriation are all of acute concern.
The BPI is not the last word on where to invest, but it does offer simple summary statistics to investors who don't have time to research all of these 102 markets in depth. In the past, organizations such as the California Public Employees Retirement System provided multi-factor assessments of foreign markets, and these were useful public goods for the investing community. I hope the BPI will follow in that admirable tradition. For inquiries about the BPI, please contact me here.
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Explanatory paragraph for chart
The Baseline Profitability Index (BPI) ranks countries by their overall attractiveness as targets for a generic foreign investment. The index values offer a better idea of how far countries are from each other. In addition to the overall rank, the countries are ranked by the three main components of the index: asset growth, preservation of value, and repatriation of capital. These are treated as independent, though they are often correlated in practice. Note that countries whose currencies are expected to appreciate in real terms will rank higher for repatriation of capital, all other things equal. The time horizon envisioned for investment is five years.
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